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An Overview Of The Housing/Credit Crisis And Why There Is More Pain To Come T2 Accredited Fund, LP Tilson Offshore Fund, Ltd. T2 Qualified Fund, LP June 2, 2009


T2 Partners Management L.P. Is A Registered Investment Advisor 145 E. 57th Street 10th Floor New York, NY 10022 (212) 386-7160 Info@T2PartnersLLC.com www.T2PartnersLLC.com


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Value Investor Insight and SuperInvestor Insight

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For the Second Half of the 20th Century, Housing Was a Stable Investment 300 Shiller Lawler Real Home Price Index (1890=100)

275 250 225 200 175

Trend Line 150 125

8 19 9

4 19 9

0 19 9

6 19 8

2 19 8

8 19 7

4 19 7

0 19 7

6 19 6

2 19 6

8 19 5

4 19 5

19 5

0

100

Source: Robert J. Shiller, Irrational Exuberance, Princeton University Press 2000, Broadway Books 2001, 2nd edition, 2005, also Subprime Solution, 2008, as updated by the author at http://www.econ.yale.edu/~shiller/data.htm; Lawler Economic & Housing Consulting 7


…And Then Housing Prices Exploded

300 Shiller Lawler Real Home Price Index (1890=100)

275 250 225

Housing Bubble

200 175

Trend Line 150 125

20 06

02 20

19 98

94 19

19 90

86 19

19 82

78 19

19 74

70 19

19 66

62 19

58 19

4 19 5

19 50

100

SOURCES: Robert J. Shiller, Irrational Exuberance: Second Edition, as updated by the author; Lawler Economic & Housing Consulting. 8


From 2000-2006, the Borrowing Power of a Typical Home Purchaser Nearly Tripled $400,000 Pre-Tax Income Borrowing Power

$300,000

$200,000

9.2x in January 2006

$100,000

3.3x in January 2000 $0 Jan-95

Jan-96

Jan-97

Jan-98

Jan-99

Jan-00

Jan-01

Jan-02

Jan-03

Jan-04

Jan-05

Jan-06

Jan-07

Jan-08

Factors contributing to the ability to borrow more and more were: 1. Slowly rising income 2. Lenders being willing to allow much higher debt-to-income ratios 3. Falling interest rates 4. Interest-only mortgages (vs. full amortizing) 5. No money down Source: Amherst Securities

9


Housing Became Unaffordable in Many Areas 80 Riverside, CA Los Angeles, CA San Diego, CA

70

Housing Opportunity Index

60 50 40 30 20 10

07 20

06 3 Q

Q

3

20

20 05 Q

3

20 04 Q

3

20 02 Q 1

1 20 0 Q 1

00 Q 1

20

99 Q 1

19

98 19 Q 1

19 Q 1

Q

1

19

96

97

0

SOURCES: NAHB/Wells Fargo Housing Opportunity Index, which measures percentage of households that could afford the average home with a standard mortgage

10


Americans Have Borrowed Heavily Against Their Homes Such That the Percentage of Equity in Their Homes Has Fallen Below 50% for the First Time on Record Since 1945

$12,000

90% 80%

$10,000 70%

Mortgage Debt (Bn)

$6,000

60% 1945 Mortgage Debt: $18.6 billion Equity: $97.5 billion

50% 2008 Mortgage Debt: $10.5 trillion Equity: $8.5 trillion

$4,000

40% 30%

Equity as a % of Home Value

$8,000

20% $2,000 10% $0

0% 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

SOURCE: Federal Reserve Flow of Fund Accounts of the United States 11


There Was a Dramatic Decline in Mortgage Lending Standards from 2001 through 2006 Combined Loan to Value

100% Financing

86

18% 17% 84

84

16% 83

81

14%

14%

81

80

12% Percent of Originations

Combined Loan to Value (%)

82

78 76 76 74 74

74

10% 9% 8% 8%

6%

72

4%

70

2%

68

0% 2001

2002

2003

2004

2005

2006

2007

3%

1%

1%

2001

2002

2003

2004

2005

2007

100% Financing & Limited Doc

Limited Documentation

12%

70% 65%

11%

63% 60%

10%

56%

49%

50% 45%

39%

40%

8%

8% Percent of Originations

Percent of Originations

2006

33% 30%

6% 5% 4% 4%

20%

2%

1%

10%

0%

0%

2001

2002

0%

0% 2001

2002

2003

2004

2005

2006

2007

2003

2004

2005

2006

2007

• In 2005, 29% of new mortgages were interest only — or less, in the case of Option ARMs — vs. 1% in 2001 • In 1989, the average down payment for firsttime home buyers was 10%; by 2007, it was 2% • The sale of new homes costing $750,000 or more quadrupled from 2002 to 2006. The construction of inexpensive homes costing $125,000 or less fell by two-thirds

SOURCES: Amherst Securities, LoanPerformance; USA Today (www.usatoday.com/money/economy/housing/2008-12-12-homeprices_N.htm)

12


Among the Many Causes of The Great Mortgage Bubble, Two Stand Out •

The companies making crazy loans didn’t care very much if the homeowner ended up defaulting for two reasons: 1. Either they didn’t plan to hold the loan, but instead intended to pass it along to Wall Street, which would bundle, slice-and-dice it and sell it (along with any subsequent losses) to investors around the world; 2. Or, if they did plan to hold the loan, they assumed home prices would keep rising, such that homeowners could either refinance before loans reset or, if the homeowner defaulted, the losses (i.e., severity) would be minimal.

There were many other reasons, of course – a bubble of this magnitude requires what Charlie Munger calls “Lollapalooza Effects” – –

– – – – –

The entire system – real estate agents, appraisers, mortgage lenders, banks, Wall St. firms and ratings agencies – became corrupted by the vast amounts of quick money to be made Regulators and politicians were blinded by free market ideology or the dream that all Americans should own their homes, causing them to fall asleep at the switch, not want to take the punch bowl away and/or get bought off by the industries they were supposed to be overseeing Debt became increasingly available and acceptable in our culture Millions of Americans became greedy speculators and/or took on too much debt Greenspan kept interest rates too low for too long Institutional investors stretched for yield, didn’t ask many questions and took on too much leverage In general, everyone was suffering from irrational exuberance

13


As Long As Home Prices Rise Rapidly, Even Subprime Mortgages Perform Well – But If Home Prices Fall, Look Out Below! Cumulative Five-Year Loss Estimates for a Bubble-Era Pool of Subprime Mortgages

60%

50%

Cumulative Loss (%)

40%

30%

20%

10%

0% 20%

15%

10%

5%

0%

-5%

-10%

-15%

-20%

-25%

-30%

-35%

-40%

Home Price Appreciation

Source: T2 Partners estimates 14


Deregulation of the Financial Sector Led to a Surge of Leverage, Profits and Compensation Ratio of Financial Services Wages to Nonfarm Private-Sector Wages, 1910-2006

• Among the most profitable areas for Wall Street firms was producing Asset-Backed Securities (ABSs) and Collateralized Debt Obligations (CDOs) • To produce ABSs and CDOs, Wall Street needed a lot of loan “product” • Mortgages were a quick, easy, big source • It is easy to generate higher and higher volumes of mortgage loans: simply lend at higher loan-to-value ratios, with ultra-low teaser rates, to uncreditworthy borrowers, and don’t bother to verify their income and assets (thereby inviting fraud) • There’s only one problem: DON’T EXPECT TO BE REPAID! Source: Ariell Reshef, University of Virginia; Thomas Philippon, NYU; Wall St. Journal, 5/14/09

15


Over the Past 30 Years, We Have Become a Nation Gorged in Debt – To The Benefit of Financial Services Firms

Low Debt Era

Rising Debt Era

2.5%

350%

300%

2.0% 250%

Total Debt

1.5%

Financial Profits

200%

1.0% 0.5% 0.0% Dec- 51 54 57 60 63 66 69 72 75 78 81 84 87 90 93 96 99 02 05

150%

Total Debt as Percent of GDP

Financial Profits as Percent of GDP

3.0%

100%

Sources: Federal Reserve, BEA, as of Q2 2007, GMO presentation 16


There Was a Surge of Toxic Mortgages Over the Past 10 Years $4,000

$3,500

Originations (Bn)

$3,000

Conforming, FHA/VA Jumbo Alt-A Subprime Seconds

$2,500

$2,000

$1,500

$1,000

$500

$0 1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

SOURCE: Inside Mortgage Finance, published by Inside Mortgage Finance Publications, Inc. Copyright 2009. 17


Private Label Mortgages (Those Securitized by Wall St.) Are 15% of All Mortgages, But Are 51% of Seriously Delinquent Mortgages Approximately two-thirds of homes have mortgages and of these, 56% are owned or guaranteed by the two government-sponsored enterprises (GSEs), Fannie & Freddie

Number of Mortgages (million)

Number of Seriously Delinquent Mortgages (000) Banks & Thrifts 397

Banks & Thrifts 8 Fannie Mae 18

15%

Fannie Mae 444 Freddie Mac 232

Private Label 8

Ginne Mae/FHA 378

Ginne Mae/FHA 6

Private Label 1734

Freddie Mac 13

51% SOURCE: Freddie Mac, Q4 2008. 18


Q 4 Q 19 4 7 Q 19 9 4 80 Q 19 4 8 Q 19 1 4 82 Q 19 4 8 Q 19 3 4 84 Q 19 4 8 Q 19 5 4 86 Q 19 4 87 Q 19 4 88 Q 19 4 89 Q 1 99 4 0 Q 19 4 91 Q 19 4 92 Q 19 4 93 Q 19 4 9 Q 19 4 4 95 Q 19 4 9 Q 19 6 4 97 Q 19 4 9 Q 19 8 4 99 Q 20 4 0 Q 20 0 4 01 Q 20 4 0 Q 20 2 4 03 Q 20 4 0 Q 20 4 4 05 Q 20 4 06 Q 2 00 4 7 20 08

Percentage of Home Loans

Over 9% of Mortgages on 1-to-4-Family Homes Were Delinquent or in Foreclosure as of Q1 2009

10.0%

9.0%

8.0%

7.0%

6.0%

5.0%

4.0%

3.0%

2.0%

1.0%

0.0%

SOURCE: National Delinquency Survey, Mortgage Bankers Association. Note: Delinquencies (60+ days) are seasonally adjusted. 19


All Types of Loans, Led by Subprime, Are Seeing a Surge in Delinquencies 45% 40%

Percent Noncurrent

35%

Alt A Option ARM Jumbo Subprime Prime Home Equity Lines of Credit

30% 25% 20% 15% 10% 5%

Q 1

19 Q 99 3 19 Q 99 1 20 Q 00 3 20 Q 00 1 20 Q 01 3 20 Q 01 1 20 Q 02 3 20 Q 02 1 20 Q 03 3 20 Q 03 1 20 Q 04 3 20 Q 04 1 20 Q 05 3 20 Q 05 1 20 Q 06 3 20 Q 06 1 20 Q 07 3 20 Q 07 1 20 Q 08 3 20 08

0%

SOURCES: Amherst Securities, LoanPerformance; National Delinquency Survey, Mortgage Bankers Association; FDIC Quarterly Banking Profile; T2 Partners estimates. Note: Prime is seasonally adjusted.

20


The Decline in Lending Standards Led to a Surge in Subprime Mortgage Origination $700

25%

$600 20% 20%

20%

18%

% of T ota l

$500 Origina tions (Bn)

15% $400

$300 10%

10%

10% 9%

9%

9%

10%

10% 8% 7%

$200

8%

7%

5% $100

$0

0% 1994

1995

1996

1997

1998

1999

2000

2001

Source: Reprinted with permission; Inside Mortgage Finance, published by Inside Mortgage Finance Publications, Inc. Copyright 2009.

2002

2003

2004

2005

2006

2007

21


The Wave of Resets from Subprime Loans Is Mostly Behind Us $35

We are here

$30

Loans with Payment Shock (Bn)

$25

$20

$15

$10

$5

Sources: LoanPerformance, Deutsche Bank; slide from Pershing Square presentation, How to Save the Bond Insurers, 11/28/07.

Ju l-1 0 O ct -1 0

Ja n10 A pr -1 0

Ju l-0 9 O ct -0 9

O ct -0 8 Ja n09 Ap r09

Ap r-0 8 Ju l-0 8

Ju l-0 7 O ct -0 7 Ja n08

Ja n07 A pr -0 7

Ju l-0 6 O ct -0 6

Ja n06 A pr -0 6

$0

22


Numerous Areas of the Mortgage Market Will Suffer Significant Losses Going Forward

Prime Mortgage Commercial Real Estate Alt-A Other Corporate Commercial & Industrial Subprime High-Yield / Leveraged Loans Jumbo Prime Home Equity Credit Card Auto Option ARM Construction & Development Other Consumer CDO/ CLO

$0.0

$0.5

$1.0

$1.5

$2.0

$2.5

$3.0

$3.5

$4.0

$4.5

$5.0

Amount Outstanding (Trillions) SOURCES: Federal Reserve Flow of Funds Accounts of the United States, IMF Global Financial Stability Report October 2008, Goldman Sachs Global Economics Paper No. 177, FDIC Quarterly Banking Profile, OFHEO, S&P Leverage Commentary & Data, T2 Partners estimates.

23


Two Waves of Losses Are Behind Us… But Three Are Looming Losses Mostly Behind Us • Wave #1: Borrowers committing (or the victim of) fraud & speculators, who defaulted quickly. Timing: beginning in late 2006 (as soon as home prices started to fall) into 2008. Mostly behind us. • Wave #2: Borrowers who defaulted when their mortgages reset due to payment shock. Timing: early 2007 (as two-year teaser subprime loans written in early 2005 started to reset) to the present. Now tapering off as low interest rates mitigate payment shock. Losses Mostly Ahead of Us • Wave #3: Prime loans (most of which are owned or guaranteed by the GSEs) defaulting due to job loss and home price declines (i.e., underwater homeowners). Timing: started to surge in early 2008 to the present. • Wave #4: Jumbo prime, second lien and HELOCs (most of which are on banks’ books) defaulting due to job loss and home price declines/ underwater homeowners. Timing: started to surge in early 2008 to the present. • Wave #5: Losses among loans outside of the housing sector, the largest of which will be in the $3.5 trillion area of commercial real estate. Timing: started to surge in early 2008 to the present.

24


Recent Signs of Stabilization Are Likely the Mother of All Head Fakes •

Rather than representing a true bottom, recent signs of stabilization are likely due to two short-term factors: 1. Home sales and prices are seasonally strong in April, May and June due to tax refunds and the spring selling season 2. A temporary reduction in the inventory of foreclosed homes – Shortly after Obama was elected, his administration promised a new, more robust plan to stem the wave of foreclosures so the GSEs and many other lenders imposed a foreclosure moratorium – Early this year, the Obama administration unveiled its plan, the Homeowner Affordability and Stabilization Plan, which is a step in the right direction – but even if it is hugely successful, we estimate that it might only save 20% of homeowners who would otherwise lose their homes – The GSEs and other lenders are now quickly moving to save the homeowners who can be saved – and foreclose on those who can’t – This is necessary to work our way through the aftermath of the bubble, but will lead to a surge of housing inventory later this year, which will further pressure home prices 25


There Is a Surge of Notices of Default and Foreclosures Among the GSEs

Prime Notices of Default

Subprime Notices of Default

Prime Foreclosures

Subprime Foreclosures

SOURCE: The Field Check Group. 26


Future Losses Will Be Driven By Three Primary Factors 1. The Economy •

Especially unemployment

2. Interest rates • •

Ultra-low rates have helped mitigate some of the damage But if the recent spike in rates continues, it could lead to an even greater surge in defaults and losses

3. Behavior of homeowners who are underwater • • • •

Roughly one-fourth of homeowners with mortgages are currently underwater, some deeply so For many, it is economically rational for them to walk – so called “jingle mail” – but how many will do so? There is little historical precedent – we are in uncharted waters As home prices continue to fall and homeowners become more and more underwater, they are obviously more likely to default, thereby creating a vicious cycle, but what exactly will the relationship be? Have millions of foreclosures led to a diminution of the stigma of losing one’s home? Our best guess is that there will be rough symmetry: for homeowners 5% underwater, an additional 5% will default due to being underwater; 10% underwater will lead to 10% more defaults, and so forth… 27


24% of Homeowners With a Mortgage Owe More Than the Home Is Worth, Making Them Much More Likely to Default Among people who bought homes in the past five years, 30%+ are underwater* In Bubble Markets, Far More Homeowners Are Underwater Price Drop Since Peak -15.2% -32.0% -21.8% -24.8% -36.6% -27.8% -10.4% -34.4% -37.7% -41.8%

* The actual figures are likely even worse, as this data doesn’t capture people who bought since 2003 and subsequently did a cash-out refi or after-the-fact second mortgage. 50% of all subprime and Alt-A loans in existence when the collapse happened were cash-out refis that carried a higher loan balance than the original purchase loan amount.

% of Last 5 Yrs Purchasers Who Are Under Water* 23.0% 56.4% 27.8% 25% 50.3% 65.1% 51.2% 23.2% 20% 63.9% 36.4% 61.4% Percent Underwater

Metro Area New York Los Angeles Boston Washington Miami San Francisco Atlanta San Diego Phoenix Las Vegas

Price Index Is at Lowest Level Since 2004-Q3 2003-Q4 2002-Q2 2004-Q1 2004-Q1 2003-Q3 2004-Q4 2002-Q4 2004-Q3 2003-Q4

There Has Been a Dramatic Rise in Homeowners Who Are Underwater 24%

20%

16%

15%

10%

6% 5%

4%

0% Dec-06

Dec-07

Sep-08

Source: Zillow.com Q4 08 Real Estate Market Report; Moody's Economy.com, First American CoreLogic, T2 Partners estimates

Dec-08

Mar-09

28


Certain Types of Loans Are Severely Underwater 80% 73% 70%

Percent Underwater

60% 50%

50% 45% 40%

30% 25% 20%

10%

0% Prime

Alt A

Subprime

Option ARM

SOURCES: Amherst Securities, LoanPerformance, Standard & Poor’s. 29


Outlook for Housing Prices • •

We think housing prices will reach fair value/trend line, down 40% from the peak based on the S&P/Case-Shiller national (not 20-city) index, which implies a 5-10% further decline from where prices where as of the end of Q1 2009. It’s almost certain that prices will reach these levels The key question is whether housing prices will go crashing through the trend line and fall well below fair value. Unfortunately, this is very likely. In the long-term, housing prices will likely settle around fair value, but in the short-term prices will be driven both by psychology as well as supply and demand. The trends in both are very unfavorable – –

• • • •

Regarding the former, national home prices have declined for 33 consecutive months since their peak in July 2006 through April 2009 and there’s no end in sight, so this makes buyers reluctant – even when the price appears cheap – and sellers desperate. Regarding the latter, there is a huge mismatch between supply and demand, due largely to the tsunami of foreclosures. In March 2009, distressed sales accounted for just over 50% of all existing home sales nationwide – and more than 57% in California. In addition, the “shadow” inventory of foreclosed homes already likely exceeds one year and there will be millions more foreclosures over the next few years, creating a large overhang of excess supply that will likely cause prices to overshoot on the downside, as they are already doing in California.

Therefore, we expect housing prices to decline 45-50% from the peak, bottoming in mid-2010 We are also quite certain that wherever prices bottom, there will be no quick rebound There’s too much inventory to work off quickly, especially in light of the millions of foreclosures over the next few years While foreclosure sales are booming in many areas, regular sales by homeowners have plunged, in part because people usually can’t sell when they’re underwater on their mortgage and in part due to human psychology: people naturally anchor on the price they paid or what something was worth in the past and are reluctant to sell below this level. We suspect that there are millions of homeowners like this who will emerge as sellers at the first sign of a rebound in home prices Finally, we don’t think the economy is likely to provide a tailwind, as we expect it to contract the rest of 2009, stagnate in 2010, and only then grow tepidly for some time thereafter 30


19 Q 99 3 19 Q 99 1 20 Q 00 3 20 Q 00 1 20 Q 01 3 20 Q 01 1 20 Q 02 3 20 Q 02 1 20 Q 03 3 20 Q 03 1 20 Q 04 3 20 Q 04 1 20 Q 05 3 20 Q 05 1 20 Q 06 3 20 Q 06 1 20 Q 07 3 20 Q 07 1 20 Q 08 3 20 08

Q 1

Percent Noncurrent (60+ days)

Delinquencies of Prime Mortgages Are Soaring 5.0%

4.5%

4.0%

3.5%

3.0%

2.5%

2.0%

1.5%

1.0%

0.5%

0.0%

SOURCE: Mortgage Bankers Association National Delinquency Survey. 31


15 States With the Highest Prime Mortgage Foreclosure Rates

SOURCE: New York Times, 5/24/09. 32


Delinquencies of Prime and Alt-A Mortgages Are Soaring

SOURCE: New York Times, 5/24/09. 33


There Are $2.4 Trillion of Alt-A Mortgages and Their Resets Are Mostly Ahead of Us $300

$10

We are here

$9

$6 $150

Amount (Bn)

$200

$7

$5 $4

$100

$3

$50

$2

Estimated Cumulative Reset Amount (Bn)

$250

$8

$1 $0

l-1 5 Ju

n15 Ja

4 l-1 Ju

n14 Ja

l-1 3 Ju

n13 Ja

2 l-1 Ju

n12 Ja

l- 1 1 Ju

Ja n11

0 l-1 Ju

Ja

n10

$0

SOURCES: Credit Suisse, LoanPerformance. NOTE: This chart only shows resets for a small fraction of Alt-A loans, but is representative of all of them.

34


n99 Ju l-9 Ja 9 n0 Ju 0 l-0 Ja 0 n01 Ju l-0 Ja 1 n0 Ju 2 l-0 Ja 2 n03 Ju l-0 Ja 3 n0 Ju 4 l-0 Ja 4 n05 Ju l-0 Ja 5 n0 Ju 6 l-0 Ja 6 n07 Ju l-0 Ja 7 n0 Ju 8 l-0 Ja 8 n09

Ja

Percent Noncurrent (60+ days)

Delinquencies of Securitized Alt-A Mortgages Are Soaring 25%

20%

15%

10%

5%

0%

SOURCES: Amherst Securities, LoanPerformance. 35


Alt-A Delinquencies By Vintage Show the Collapse in Lending Standards in 2006 and 2007 30% 2007

2006

Percent Noncurrent (60+ days)

25%

20%

15% 2005 10% 2004 5%

2003

0% 0

5

10

15

20

25

30

35

40

45

50

55

60

Months of Seasoning SOURCES: Amherst Securities, LoanPerformance. 36


n99 Ju l-9 Ja 9 n0 Ju 0 l-0 Ja 0 n01 Ju l-0 Ja 1 n02 Ju l-0 Ja 2 n03 Ju l-0 Ja 3 n04 Ju l-0 Ja 4 n05 Ju l-0 Ja 5 n06 Ju l-0 Ja 6 n07 Ju l-0 Ja 7 n08 Ju l-0 Ja 8 n09

Ja

Percent Noncurrent (60+ days)

Delinquencies of Securitized Jumbo Prime Mortgages Are Soaring 4.0%

3.5%

3.0%

2.5%

2.0%

1.5%

1.0%

0.5%

0.0%

SOURCES: Amherst Securities, LoanPerformance. 37


HELOCs and Home Equity Loans Soared in Popularity During the Bubble $1,000 Closed-End Junior Lien Mortgages $900

Home Equity Lines of Credit

$800

Amount (Bn)

$700 $600 $500 $400 $300 $200 $100

08 20

07

1 Q

Q 1

20

06 Q 1

20

05 Q 1

20

4

20 03

20 0 Q 1

1 Q

Q 1

20 02

01 20 Q 1

Q 1

20

00

$0

Note: Does not include approximately $200 billion of securitized HELOCs and junior liens. SOURCE: FDIC Quarterly Banking Profile. 38


Many Borrowers Used HELOCs to Buy New Cars • •

As home prices have declined and other funding sources have dried up, millions of consumers have maxed out on home equity debt. In hot markets like California and Florida, a significant percentage of all consumers tapped into the value of their homes to help finance their new cars, according to CNW Marketing Research.

Clearly this dynamic does not bode well for HELOC recovery rates or new car sales.

SOURCE: New York Times 5/27/2008. 39


Delinquencies of HELOCs and CESs Are Soaring 4.5% Closed-End Junior Lien Mortgages Home Equity Lines of Credit

Percent Noncurrent (90+ days)

4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5%

04 20 Q 04 4 2 Q 004 1 20 Q 05 2 2 Q 005 3 20 Q 05 4 20 Q 05 1 20 Q 06 2 2 Q 006 3 20 Q 06 4 2 Q 006 1 20 Q 07 2 20 Q 07 3 2 Q 007 4 20 Q 07 1 2 Q 008 2 20 Q 08 3 2 Q 008 4 20 Q 08 1 20 09 Q

3

20

2 Q

Q

1

20 0

4

0.0%

SOURCE: FDIC Quarterly Banking Profile. 40


A Primer on Option ARMs • • •

• • • • • •

An Option ARM is an adjustable rate mortgage typically made to a prime borrower Sold under various names such as “Pick-A-Pay” Banks typically relied on the appraised value of the home and the borrower’s high FICO score, so 83% of Option ARMs written in 2004-2007 were low- or no-doc (liar’s loans) Each month, the borrower can choose to pay: 1) the fully amortizing interest and principal; 2) full interest; or 3) an ultra-low teaser interest-only rate (typically 2-3%), in which case the unpaid interest is added to the balance of the mortgage (meaning it is negatively amortizing) Approximately 80% of Option ARMs are negatively amortizing Lenders, however, booked earnings as if the borrowers were making full interest payments A typical Option ARM is a 30- or 40-year mortgage that resets (“recasts”) after five years, when it becomes fully amortizing If an Option ARM negatively amortizes to 110-125% of the original balance (depending on the terms of the loan), this triggers a reset even if five years have not elapsed Upon reset, the average monthly payment can jump significantly, though the payment shock is currently mitigated by ultra-low interest rates ‘My sense is that many option ARM borrowers are in a worse position than subprime borrowers,’ says Kevin Stein, associate director of the California Reinvestment Coalition, which combats predatory lending. ‘They wind up owing more and the resets are more significant.’

41


About $750 Billion of Option ARMs Were Written, Nearly All at the Peak of the Bubble 9%

$300 9%

8% 8%

$250

7% 6% 5%

5% 5%

$150

4%

Percent of Total

Originations (Bn)

$200

3%

$100

2% $50 1% $0

1% 0%

2004

2005

2006

2007

2008

SOURCES: 2008 Mortgage Market Statistical Annual, published by Inside Mortgage Finance Publications, Inc. Copyright 2008. T2 Partners estimates. 42


Options ARMs Were a Bubble State Phenomenon

Other 25%

Arizona 3% Nevada 3%

California 58%

Florida 10%

SOURCES: Amherst Securities, LoanPerformance. 43


Beginning in March 2005, High-FICO-Score Borrowers Opted for an Above-Market-Rate Option ARM in Exchange for the Low Teaser Rate 8.5 Fannie Mae 30 Year FRM Index Option ARM Index 8.0

7.5

Interest Rate (%)

7.0

Nearly all option ARM borrowers during this period (when nearly all option ARMS were written) can’t afford a fullyamortizing mortgage – otherwise they would have taken one

6.5

6.0

5.5

5.0

4.5

Ja n02 A pr -0 2 Ju l-0 2 O ct -0 2 Ja n03 A pr -0 3 Ju l-0 3 O ct -0 3 Ja n04 Ap r-0 4 Ju l-0 4 O ct -0 4 Ja n05 A pr -0 5 Ju l-0 5 O ct -0 5 Ja n06 A pr -0 6 Ju l-0 6 O ct -0 6 Ja n07 A pr -0 7 Ju l-0 7 O ct -0 7 Ja n08

4.0

SOURCE: Amherst Securities, BloombergFinance, L.P. 44


n99 Ju l-9 Ja 9 n0 Ju 0 l-0 Ja 0 n01 Ju l-0 Ja 1 n02 Ju l-0 Ja 2 n03 Ju l-0 Ja 3 n04 Ju l-0 Ja 4 n05 Ju l-0 Ja 5 n06 Ju l-0 Ja 6 n07 Ju l-0 Ja 7 n08 Ju l-0 Ja 8 n09

Ja

Percent Noncurrent (60+ days)

Delinquencies of Securitized Option ARMs Are Soaring 35%

30%

25%

20%

15%

10%

5%

0%

SOURCES: Amherst Securities, LoanPerformance, T2 Partners estimates. 45


Option ARM Delinquencies By Vintage Show the Collapse in Lending Standards in 2005-2007

45%

2006

40%

Percent Noncurrent (60+ days)

35%

2007

30%

2005 25%

20%

2004 15%

2003

10%

5%

0% 0

5

10

15

20

25

30

35

40

45

50

55

60

Months of Seasoning

SOURCE: Amherst Securities, LoanPerformance. 46


Existing Homes Sales Are Falling and Foreclosures Are Rising, Leading to a Surge in Inventories

Existing Home Sales 7.5

7.0

Millions

6.5

6.0

Months Supply

5.5

12 11

5.0

4.7 million units as of the end of April 2009

4.5

9

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

Months

4.0 1999

4.0 million units, equal to 10.2 months as of the end of April 2009

10

8 7 6 5 4 3 1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

SOURCE: NATIONAL ASSOCIATION OF REALTORS速 Existing Home Sales data series. 47


Foreclosure Filings Have Increased Dramatically

400,000 350,000

300,000

250,000 200,000

150,000

100,000

50,000 0 Ju n Au -05 gO 05 ct De 05 cFe 05 bAp 06 rJu 0 6 nAu 06 gO 06 ct D -06 ec F e 06 bAp 07 rJu 0 7 nA u 07 gO 07 ct D 07 ec Fe 07 bA p 08 rJu 0 8 n Au -08 gO 08 ct De 08 cFe 08 bAp 09 r- 0 9

Foreclosures in April rose 32% year-over-year, but only 1% sequentially April was the highest monthly total since RealtyTrac began issuing its report in January 2005 despite a decrease in bank repossessions (REOs) RealtyTrac estimates that over 1.5 million bank-owned properties are on the market, representing around a third of all properties for sale in the U.S.

Number of Foreclosures

• •

Note: Foreclosure filings are defined as default notices, auction sale notices and bank repossessions. SOURCE: RealtyTrac.com U.S. Foreclosure Market Report.

48


Home Prices Are in an Unprecedented Freefall 220 S&P/Case-Shiller U.S. National Home Price Index S&P/Case-Shiller 20-City Composite OFHEO Purchase-Only Index NAR Median Sales Price of Existing Homes

200

180

160

140

120

3

Q

Q

1

20 0

0 20 Q 00 1 20 Q 01 3 20 Q 01 1 20 Q 02 3 20 Q 02 1 20 Q 03 3 20 Q 03 1 20 Q 04 3 20 Q 04 1 20 Q 05 3 20 Q 05 1 20 Q 06 3 20 Q 06 1 20 Q 07 3 20 Q 07 1 20 Q 08 3 20 Q 08 1 20 09

100

SOURCES: Standard & Poor’s, OFHEO Purchase-Only Index, NATIONAL ASSOCIATION OF REALTORS® Existing Home Sales data series. 49


Home Prices Need to Fall Another 5-10% to Reach Trend Line 300 Shiller Lawler Real Home Price Index (1890=100)

275 250 225

Housing Bubble

200 175

Trend Line 150 125

20 06

02 20

19 98

94 19

19 90

86 19

19 82

78 19

19 74

70 19

19 66

62 19

58 19

4 19 5

19 50

100

SOURCES: Robert J. Shiller, Irrational Exuberance: Second Edition, as updated by the author; Lawler Economic & Housing Consulting. 50


Tre nd Line

0.8 0.3

1.5 1.0

Tre nd Line

0.5 0.0

2.0 1.8

U.S. Dollar

U.K. Pound

1979-1992

1979-1985

1.6 1.4 1.2 1.0 0.8 79

81

83

2000

85

87

89

0.9 0.8 79

80

81

82

83

Gold

Crude Oil

1970-1999

1962-1999

80

1992-October 2008

1.5 1.0 0.5 0.0

Tre nd Line

2.4 2.0 1.6 1.2

1.4 1.3

92 94 96 98 00 02 04 06 08

Japanese Yen

Japanese Yen

1983-1990

1.2 1.1 1.0 0.9 0.8

Commodities 250

1.2 1.1 1.0 0.9 0.8 92

40 20 0

0 70

74

78

82

86

90

94

98

95

96

Cocoa 1970-1999

600 500

150 100 50 0

62 66 70 74 78 82 86 90 94 98

94

Nickel

Real Price

400

Real Price

Real Price

800

60

93

1979-1999

200

1200

1992-1998

1.4 1.3

83 84 85 86 87 88 89 90

84

Trend Line

0.8

81 83 85 87 89 91 93 95 97 99

Currencies

1.2 1.1 1.0

91

1600 Real Price

1.4 1.3

S&P 500

1981-1999

3.0 2.5 2.0

46 50 54 58 62 66 70 74 78 82

Cumulative Return

Cumulative Return

20 21 22 23 24 25 26 27 28 29 30 31

Cumulative Return

1.3

2.0

Japan vs. EAFE ex-Japan Detrended Real Price

1.8

2.5

Stocks

Cumulative Return

S&P 500 1946-1984

Relative Return

2.3

S&P 500 1920-1932 Detrended Real Price

Detrended Real Price

A Study of Bubbles Shows That All of Them Eventually Return to Trend Line

79 81 83 85 87 89 91 93 95 97

97

400 300 200 100 0 70 74

78 82 86 90

94 98

SOURCE: GMO LLC. Note: For S&P charts, trend is 2% real price appreciation per year. Source: GMO. Data through 10//10/08. * Detrended Real Price is the price index divided by CPI+2%, since the long-term trend increase in the price of the S&P 500 has been on the order of 2% real.

51


The Biggest Danger is That Home Prices Overshoot on the Downside, Which Often Happens When Bubbles Burst S&P 500 1927-1954 2.50

Overrun: 59% Fair Value to Bottom: 1.5 Years Fair Value to Fair Value: 23 Years

2.00 1.75 1.50 1.25

S&P 500 1955-1986

1.00 2.25

0.75

2.00

0.50

-59%

0.25 0.00 1927

1930

1933

1936

1939

1942

1945

1948

1951

1954

Detrended Real S&P 500 Stock Price Index

Detrended Real S&P 500 Stock Price Index

2.25

Overrun: 45% Fair Value to Bottom: 7 Years Fair Value to Fair Value: 12 Years

1.75 1.50 1.25 1.00 0.75 0.50

-45% 0.25 0.00 1955 1957 1959 1961 1963 1965 1967 1969 1971 1973 1976 1978 1980 1982 1984 1986

SOURCE: GMO LLC, T2 Partners calculations. 52


In Bubble Markets, Prices Are Way Down, Driven By a Surge in the Number of Homes Sold Out of Foreclosure

$500

California

70%

60%

50% $300

40%

30%

$200

Foreclosure Resale %

Median Home Price (000s)

$400

20% $100 10%

ct -0 8 Ja n09 Ap r-0 9

O

l-0 8 Ju

r-0 8 Ap

7

-0 8 Ja n

ct -0

7

7 O

Ju l-0

r-0 Ap

07 Ja n-

ct -0 6 O

l-0 6 Ju

6

0% Ap r-0

Ja

n0

6

$0

SOURCE: MDA Dataquick. Note: Includes new construction 53


Home Prices Have Crashed Through the Trend Line in California, But Stabilized in March $600 Median Sales Price 4% Trend

Median Price ($000s)

$500

$400

$300

$200

$100

1 Ja n03 Ja n05 Ja n07 Ja n09

n0 Ja

-9 9 Ja n

5

97 Ja n-

n9 Ja

n93 Ja

9

91 Ja n-

n8 Ja

-8 7 Ja n

3

85 Ja n-

n8 Ja

-8 1 Ja n

Ja n-

79

$0

SOURCE: California Association of REALTORS 速 . All rights reserved. www.rebsonline.com, T2 Partners estimates. 54


The Housing Affordability Index Shows Houses Are Now Affordable Before concluding that houses are cheap, however, there are three big caveats: first, low rates are only available to those who qualify for conforming mortgages, which doesn’t help millions of homeowners or potential homeowners who have spotty credit histories or are underwater on their current mortgages. Second, with low enough interest rates, almost anything looks affordable; if rates rise, houses won’t look so reasonably priced based on these metrics. Finally, in light of the severe economic downturn, average income may fall for quite some time.

Mortgage Payment on Median Priced Home as % of Family Income

26

24

22

20

18

16

08

07

06

05

04

09 20

20

20

20

20

03

02

01

00

99

98

97

96

95

94

93

92

91

90

SOURCE: NATIONAL ASSOCIATION OF REALTORS® Housing Affordability Index

20

20

20

20

20

19

19

19

19

19

19

19

19

19

19

19

89

14

55


Mortgage Rates Have Fallen Recently 10 Jumbo 30 Yr FRM 9

Jumbo 5/1 Hybrid ARM Conforming 30 Yr FRM Conforming 5/1 Hybrid ARM

8

10-Year Treasury

Rate (%)

7

6

5

4

3

Fe

b0 M 4 ay -0 Au 4 g0 N 4 ov -0 Fe 4 bM 05 ay -0 Au 5 g0 N 5 ov -0 Fe 5 bM 06 ay -0 Au 6 g0 N 6 ov -0 Fe 6 bM 07 ay Au 07 g0 N 7 ov -0 Fe 7 b0 M 8 ay -0 Au 8 g0 N 8 ov -0 Fe 8 bM 09 ay -0 9

2

SOURCES: HSH ASSOCIATES, Freddie Mac PMMS, Yahoo! Finance.

56


The Home Price-to-Rent Ratio Has Returned to Normal Levels 27

Median Home Price to Median Gross Rent

25

23

21

19

17

15 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

SOURCE NATIONAL ASSOCIATION OF REALTORS速 Existing Home Sales data series, U.S. Census Bureau, T2 Partners estimates 57


Are We Seeing the Beginnings of a Bottom in Hard-Hit Markets?

SOURCE: NY Times, 5/4/09. 58


Home Prices in Sacramento More Than Tripled in Six Years – And Have Now Fallen 47%

SOURCE: Zillow.com. 59


The Vast Majority of Sacramento Homeowners Who Purchased During the Bubble Years Are Now Underwater

SOURCE: Zillow.com. 60


In Sacramento Country, Home Sales Have Rebounded – But Are Still Outweighed by Defaults

Monthly Notices-of-Default in Sacramento

SOURCES: MDA Dataquick; The Field Check Group -- data provided by ForeclosureRadar.com. Note: Includes new construction.

61


Home Prices Are Stabilizing in Sacramento Country, In Part Due to More Higher End Homes Being Sold Off

Sacramento House Prices at the Time of Foreclosure/REO

Sacramento Mix of Houses at the Time of Foreclosure/REO

SOURCE: The Field Check Group -- data provided by ForeclosureRadar.com. 62


Comments From Mark Hanson (1) The Field Check Group, May 5, 2009 California housing – at the low end – is 'bottoming' mostly because: a) median prices are down 55% from their peak over the past two years, thereby making the low end affordable; b) foreclosures have temporarily been cut by 66% through moratoriums reducing supply; and c) demand is picking up going into the busy season. But the moratoriums are ending and the number of foreclosures in the pipeline is massive – they will start showing themselves as REO over the near to mid-term. The Obama plan held the foreclosure wave back, creating a huge backlog and now the servicers are testing hundreds of thousands of defaults against the new loss mitigation initiatives. We presently see the Notice of Defaults at record highs and Notice of Trustee Sales back up to nine-month highs – there is no reason for a loan to go to the Notice of Trustee Sale stage if indeed it wasn't a foreclosure. However, the new 'batch' are not only from the low end but a wide mix all the way up to several million dollars in present value. Because the majority of buyers are in ultra low and low-mid prices ranges, the supplydemand imbalance from foreclosures and organic supply will crush the mid-to-upper priced properties in 2009. We already have early seasonal hard data proving this. As the mid-to-upper end go through their respective implosions this year and the volume of sales in these bands increase as prices tumble, the mix shift will raise median and average house prices creating the ultimate in false bottoms. We also have data proving this phenomenon. 63


Comments From Mark Hanson (2) The Field Check Group, May 5, 2009 After a year or so the real pain will occur when the mid to upper bands are down 40% from where they are now, and the price compression has made the low to low-mid bands much less attractive – the very same bands that are so hot right now. Rents are tumbling and those that bought these properties for investment will be at risk of default (investors have been buying all the way down). Investors have just started to get taken to the woodshed from all of the supply and this will get much worse. Mid-toupper end rental supply is also flooding on the market making it much better to rent a beautiful million dollar house than putting $300,000 down and buying. After investors are punished -- and with move-up buyers gone for years – it will leave first-time homeowners to fix the housing market on their own. Good luck and good night. Five years from now when things look to be stabilizing, all of these terrible kick-the-can-down-the-road modifications that leave borrowers in 5-year-teaser, ultra-high-leverage, 150% LTV, balloon loans will start adjusting upward and it will be Mortgage Implosion 2.0. These loan mods will turn millions of homeowners into over-levered, underwater, renters and ensure housing is a dead asset class for years to come. Due to a confluence of events including a national foreclosure moratorium and near-zero sales in the mid to upper end during the off season, the broader housing data show signs of stabilization. Taken in context, it is a blip. There are no silver linings or green shoots in housing whatsoever other than by these first-time homeowners – former renters – who now find it cheaper to own than rent. This is a very good thing, but it only applies to a small segment of the population and will not be able to support the market. In addition, the first-time buyers who come out of the rental market put continuous pressure on rents. Our data shows that the mid-to-upper end housing market is on the precipice of the exact cliff that the market fell off of in 2007, led by new loan defaults. What happens to the economy when you hit the midto-upper end earners the same way the low-to-mid end was hit with the subprime implosion? We will find out soon enough. When we look back on housing at the end of 2009, anyone that made positive housing predictions this year will not believe how far off they were. 64


There Have Been 5.7 Million Jobs Lost So Far in This Recession, More Than 3 Million in the Past Five Months

Change in Nonfarm Payroll Employment (000s)

600 400

200

0 -200

-400

There have been job losses every month since December 2007

-600

-800

n9 Ja 1 n9 Ja 2 n9 Ja 3 n9 Ja 4 n9 Ja 5 n9 Ja 6 n9 Ja 7 n9 Ja 8 n9 Ja 9 n0 Ja 0 n0 Ja 1 n0 Ja 2 n0 Ja 3 n0 Ja 4 n0 Ja 5 n0 Ja 6 n0 Ja 7 n0 Ja 8 n09

Ja

Ja

n90

-1000

SOURCE: Bureau of Labor Statistics. 65


The Unemployment Rate Jumped to 8.9% in April, the Highest Level Since 1983 If part-time and discouraged workers are factored in, the unemployment rate 12% would have been 15.8% in April. In addition, the average work week in April was 33.2 hours, a record low. 11%

Unemployment Rate

10% 9% 8% 7% 6% 5% 4%

SOURCE: Bureau of Labor Statistics.

n09 Ja

n06 Ja

n03 Ja

00 Ja n-

n97 Ja

n94 Ja

n91 Ja

Ja n88

85 Ja n-

n82 Ja

n79 Ja

n76 Ja

n73 Ja

Ja n70

3%

66


The Decline from Peak Employment Now Exceeds the Past Five Recessions 0.0% 1981 - 83

1980

1990 - 93

1974 - 76

-0.5%

2001 - 05

-1.0% -1.5% -2.0% -2.5% -3.0% -3.5% -4.0% 2007-4.5% 0

6

12

18

24

30

36

42

48

Months after pre-recession peak SOURCE: Bureau of Labor Statistics 67


Consumer Confidence Rebounded in April

and May 160

140

Consumer Confidence Index

120

100

80

60

40

20

0 1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

Note: 1985=100. SOURCE: The Conference Board (www.pollingreport.com/consumer.htm) 68


Banks are Tightening Consumer Credit and New Household Borrowing Has Plunged

Percent of US Banks Tightening Consumer Credit 70% 60% 50% 40% 30% 20% 10% 0%

Household Borrowing 1990-2008 (Seasonally-Adjusted Annual Rate)

-10% $1,200

Credit Cards

Se p08

Ja n08

M ay -0 7

Se p06

Ja n06

M ay -0 5

Se p04

Ja n04

M ay -0 3

Se p02

Ja n02

M ay -0 1

($ billions)

Se p00

Ja n00

-20%

$1,000

Other Consumer Loans $800

$600

$400

$200

$0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

SOURCE: Federal Reserve Board. 69


Pools of HELOCs and CESs Can Suffer Astronomical Losses Due to 100%+ Severities On one second lien deal, Ambac expected losses of 10-12% when it guaranteed the senior tranche. A year ago, Ambac admitted that the pool would likely lose 81.8% of its value – and based on the pool’s performance since then, this will almost certainly prove to be conservative. 3.0% Ambac Projection April 2008 Actual

Monthly Loss Rate (3m average)

2.5%

2.0%

1.5%

1.0%

From Ambac slide, April 2008: • Second lien deal that closed in April 2007 • Loss to date 9.9%; projected loss: 81.8% • Projected collateral loss as a % of current collateral: 86% • A reasonable estimate of projected collateral loss for the above transaction might have been 10-12%, with the transaction having an A+ rating at inception and being structured to withstand 28-30% collateral loss

0.5%

0.0% 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47 49 51 53 55 57 59 Months Since Close SOURCES: Ambac Q1 08 presentation, Amherst Securities; funds managed by T2 Partners are short Ambac.

70


The Timing Indicates That We Are Still in the Middle Innings of the Bursting of the Great Housing Bubble • • • • • • •

Mortgage lending standards became progressively worse starting in 2000, but really went off a cliff beginning in early 2005 The worst loans were subprime ones, which generally had two-year teaser rates and are now defaulting at unprecedented rates Such loans made in Q1 2005 started to default in high numbers upon reset in Q1 2007, which not surprisingly was the beginning of the current crises The crisis has continued to worsen as even lower quality subprime loans made over the remainder of 2005 reset over the course of 2007, triggering more and more defaults It takes an average of 15 months from the date of the first missed payment by a homeowner to a liquidation (generally a sale via auction) of the home Thus, the Q1 2005 subprime loans that defaulted in Q1 2007 led to foreclosures and auctions in early 2008 Given that lending standards got much worse in late 2005 through 2006 and into the first half of 2007, and the many other types of loans that are now with longer reset dates that are now starting to default at catastrophic rates, there are sobering implications for expected defaults, foreclosures and auctions in 2009 and beyond, which promise to drive home prices down further

In summary, today we are only in the middle innings of an enormous wave of defaults, foreclosures and auctions that is hitting the United States. We predicted in early 2008 that it would get so bad that it would require large-scale federal government intervention – which has occurred, and we’re not finished yet. 71


Total Losses Are Now Estimated at $2.1-$3.8 Trillion – And Only a Fraction of This Has Been Realized To Date $4,000

$3,778

Corporate

$3,552 $3,500

Consumer Commercial Real Estate Residential Mortgages

$3,000

Amount (Bn)

$2,632 $2,500 $2,083 $2,000 $1,473 $1,500

$1,214

$1,000

GSEs Insurers

$500

Banks/ Brokers

$0 Goldman Sachs Jan 2009

Roubini Jan 2009

T2 Partners Mar 2009

IMF Apr 2009 Writedowns to Capital Raised Date

SOURCES: Goldman Sachs, International Monetary Fund, RGE Monitor, Bloomberg Finance L.P., T2 Partners estimates. 72


A Breakdown of Our Financial Sector Loss Estimates Amount (Bn) $0 CDO/ CLO Other Consumer Construction & Development Option ARM

$100

$200

$300

$400

$500

$600

$700

$800

Total Estimated Financial Sector Losses = $3.8 trillion

Auto Credit Card Home Equity Jumbo Prime High-Yield / Leveraged Loans Subprime Commercial & Industrial Other Corporate Alt-A Commercial Real Estate Prime Mortgage

SOURCE: T2 Partners estimates. 73


Institutions Have Been Able to Raise Capital to Mostly Keep Up With Writedowns, But This Will Likely Not Continue $1,500 Losses & Writedowns Capital Raised $1,250

Amount (Bn)

$1,000

$750

$500

$250

$0 Prior

Q3 2007 Q4 2007 Q1 2008 Q2 2008 Q3 2008 Q4 2008 Q1 2009 Q2 2009

SOURCE: Bloomberg Finance L.P. 74


Where We Are Finding Opportunities

• •

Blue-chips. The stocks of some of the greatest businesses, with strong balance sheets and dominant competitive positions, are trading at their cheapest levels in years – due primarily to the overall market decline and weak economic conditions rather than any company-specific issues. In this category, we’d put Coca-Cola, McDonald’s, Wal-Mart, Altria, ExxonMobil, Johnson & Johnson, and Microsoft. Out of favor blue-chips. For somewhat more adventurous investors looking to buy great companies in the most out-of-favor sectors such as financials and retailers, we own Berkshire Hathaway, Wells Fargo, American Express and Target. All are great businesses, but their stocks have suffered mightily thanks to the economic downturn. We think they’re good bets to rebound when things stabilize. Balance sheet plays. For investors who are comfortable with lower-quality businesses but want downside protection, there are many companies trading near or even below net cash on the balance sheet. Examples in our portfolio include digital media equipment company EchoStar Corp. and clothing retailer dELiA*s. Berkshire is the best of both worlds: a premier company but also a balance sheet play. Turnarounds. There are countless companies that have gotten clobbered by the economic downturn and are reporting dismal results – with stock prices to match. Investors in those that survive and return to anything close to former levels of profitability will be well rewarded – but picking these stocks isn’t easy. Among our holdings in this category are Wendy’s restaurants, Winn-Dixie supermarkets, Huntsman, a specialty chemical maker, Crosstex, a pipeline company, and Resource America, a specialty finance company. Special situations. This is somewhat of a catch-all category that, for us, includes Contango Oil & Gas, a stock that’s declined due to an aborted attempt to sell the company and the sharp drop in the price of natural gas. Mispriced options. Every once in a while we take a tiny position in a highly speculative situation – often where the stock price is below $1 – in which there’s a real chance that the outcome is zero, but also a decent chance, in our opinion, of making many multiples of our money. On an expected value basis, therefore, a small portfolio of such investments is attractive. Our holdings include General Growth Properties, TravelCenters of America, Ambassadors International, Borders Group and PhotoChannel Networks. 75


Crise presentation